introduction to micro-economics externality - pollution

Introduction to micro-economics

Externality - Pollution

• External cost (negative externality)– A cost that arises from an activity undertaken by an individual,

firm or other economic agent and that is borne by others because the cost is not incorporated in the market price the agent pays.

• External benefit (positive externality)– A benefit received by others that arises from an activity

undertaken by an individual, firm or other economic agent for which the agent is not compensated in the market price paid for the good or service provided.

• An externality is an impact (cost/benefit) on others arising from production or consumptions , which is not reflected in prices.

LO1: External Costs and Benefits and Their Affects on Resource

Allocation

Externalities

© 2012 McGraw-Hill Ryerson Limited

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Private costs and social costs diverge

• Does the honeybee keeper face the right incentives? (Part 1)– When the bee-keeper has more hives, the bees pollinate

the trees in the orchard more thoroughly, increasing the yield.

– Positive externality.• Does the honeybee keeper face the right incentives?

(Part 2)– When the bee-keeper has more hives, the more students

and nursing home residents will be stung by bees.– Negative externality.


Allocation

Externalities Distort the Allocation of Resources


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Individuals considering only their own costs and benefits will tend to engage in….

– Too much in activities that generate negative externalities.

• Market Price overestimates the benefits of the activity.• Prices do not include social costs

– Too little in activities that generate positive externalities.

• Market Price underestimates the benefits of the activity.• Price does not include the benefits


Allocation

Externalities and Resource Allocation


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The market equilibrium level of output (Qpvt) is larger than the socially optimal level (Qsoc) for products accompanied by external costs [panel (a)] but smaller than the socially optimal level for products accompanied by external benefits [panel (b)].

FIGURE 10.1: How External Costs and Benefits Affect Resource Allocation

Social MC =Private MC + XC S

D

Private MC

Qsoc

XC

XB

MC

QsocQpvtQpvt

Social demand =Private demand + XB

Private demand


Ch10-5LO1: External Costs and Benefits

and Their Affects on Resource Allocation

Coase theorem• The Coase theorem states that it is not necessary to assign liability or

regulate pollution• Provided that

– transactions costs (the costs of negotiation) are not too high, socially efficient equilibrium can be achieved regardless how the property rights are assigned.

• It does not matter whether the chemical factory has the right to pollute or the salmon fishery has the right to water that is not polluted.

• The Coase theorem fails to work because one party believes they should not need to negotiate and when the transactions costs exceed the benefit either parties could obtain by negotiation.

“Coase makes the point that which ever way the law interprets the property rights, as long as these rights are well defined and the transactions costs of enforcing and transferring them are not too great, society's resources will be used most efficiently by just letting private agents work out these problems to their own mutual benefit.”

http://faculty.wcas.northwestern.edu/~mwitte/pf/handouts/coase.html

Coase Theorem Example

• “Consider a railroad that passes through wheat fields. The passing trains let off sparks which can burn the wheat. If the legal rights are on the side of the farmers, then they could require the trains to buy and install spark catchers to eliminate these fires. However, if that is expensive (i.e. more than the value of the burned wheat), the train owners may just pay the farmers for the damage done to the crops. If the legal rights are with the trains, the farmers may just put up with burned crops or (if that is expensive) they could pay the trains to put on spark catchers. Either way, the socially efficient outcome (install spark catchers or burn crops) is what happens and the legal rights just determine who has to pay.”

• C:\Users\gmason.PRAINC\Documents\Pavtube\youtube_converter\Negative Externalities and the Coase Theorem - YouTube.mp4

• Costless negotiation and full information are very strong assumptions.– Negotiation is not always practical because:

• Many potential participants.• Contracts can be difficult / costly to enforce.• Strategic behavior / bluffing .

• In practice, many laws and regulations try to solve externality problems.

• The burden of adjustment is often assigned to those who can adjust at the lowest cost or who have the fewest resources to object.

Lo2: Policies to Offset Externalities

Legal Remedies for Externalities


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• The optimal amount of negative externalities is not necessarily zero.

• Eliminating pollution has both benefits and also costs– The best policy will eliminate pollution until the

cost of further abatement equals the benefit of further abatement.

– The cleanup effort should be expanded only until the marginal benefit equals the marginal cost.

Lo3: Optimal Externality is not Zero

Optimal Amount of Externalities


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Property Rights and the Tragedy of the Commons

• People who grow up in the industrialized nations tend to take the institution of private property for granted.

• Property rights are much more complex than simple possession.

• The idea is much broader than land or housing (termed real property or real estate)

LO4: Tragedy of the Commons and Remedies

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Property Rights


• The extent of property rights has, moreover, changed substantially over time in advanced industrial countries.

• There are many unpriced resources that nobody owns.

Slavery is the expropriation of the individual’s right to sell his/her labour

• The tendency for a resource that has no price to be used until its marginal benefit falls to zero.– One person’s use of commonly held property

imposes an external cost on others, reducing the property’s value.

• One solution: private ownership of the entire resource.– Single private owner will “internalize the

externality”.


Tragedy of the Commons


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• Defining private ownership rights does not always solve the tragedy of the commons. – Why are blackberries in public parks picked too soon?– Why does London, England, impose a tax on every

vehicle that enters the central business district during business hours?

• Enforcement of property rights may not be feasible.– Harvesting whales in international waters.– Controlling multinational environmental pollution.


When Private Ownership is Impractical


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London Congestion Charge• The London congestion charge is a

fee on most motor vehicles operating within the Congestion Charge Zone (CCZ) in between 07:00 and 18:00 (M-F).

• Claimed direct benefits– Reduced travel time (diversion to transit)– Reduced vehicle emissions leading to

lower pollution (CO2 and NO2)

• Claimed indirect– Increased revenues– Increased use of alternative transit

(bicycles)

Change in cars on the street• Blue is increase• Red decrease• Green – no change

Change in bicycles on the street• Blue is increase• Red decrease• Green – no change

10.3 Climate Change and Greenhouse Gases

Taxes to reduce pollution

Basic Tax Structures• Income taxes (progressive, regressive,

proportional or flat tax)• Consumption (Sales and GST)• Ad valorem (property, inheritance)• Poll tax (head tax – equal tax per person,

business, household)

Green Taxes• Form of consumption tax• Some advocate replacing existing taxes on employment,

incomes and profits (‘goods’) with taxes on energy use (‘bad’) • This is claimed to result in

– better overall national economic performance; – higher levels of employment; – and a cleaner environment.

• The goal is to shift the balance between human resources and natural resources.

• Taxes are well known to shift resources:– Income taxes tend to reduce work effort– Sales taxes reduce consumption (cigarettes)– Carbon taxes are intended to reduce use of fossil fuels

Green Taxes

• Problems – Green taxes are regressive because (hit poorer

people relatively harder than richer). – A tax on natural gas raises the cost of heating,

cooking and lighting, it will consumer a higher proportion of disposable income and poor people would find it harder to pay

– The effect is greater if we reduce income and prfits taxes tp really force the shift for which there are many exemptions

Rehabilitating the Green Tax1. Some studies show that redistributing the surplus as an

eco-bonus creates a progressive tax. 2. Green taxes at the retail level are regressive, but imposed

at the upstream are less so it affects all incomes – salaries, rents, profits, dividends, which tend to fall more of richer households.

3. Green taxes should form part of a broader tax reform. For example a general shift to wealth taxes and a move to value added taxes (GST) and away from income taxes.

Caution: Progressivity in taxation is not the only goal.

Other goals must be sustainability (resource allocation is not disturbed to erode the tax base), ease of administration, and enforcement.

The concept of cost minimization for abatement is related to the concept of elasticity in demand

The basic math rests on geometry and the area defined by the rectangle that shows the marginal abatement cost/tax and emission level

Total costs minimized(area a + b)

Area b

Area a

MAC = marginal abatement cost

Allowing emissions costs nothing E0 = 50

Total cost of damages foregone = e + f (total cost of abatement + avoided losses to the pollutee)

The net benefit is f

Total tax paid by the polluter is a+b+c+d, plus the abatement cost (e).

Taxes are more costly to the firm than standard

Cost of a standard (set at E*) is just e.

Why tax?

What dangers exist in using a tax

MD = marginal social cost of damages

Optimal Green Tax: MAC = MD

Cost of tax + abatement creates an incentive to invest in new technology

Industry 1: total cost = a+b+c+d+e

Industry 3: total cost = b+d+e

If the difference is technology, the gain is area a+ c

Technology lowers the MAC

Taxes to reduce pollution

Basic Tax Structures• Income taxes (progressive, regressive,

proportional or flat tax)• Consumption (Sales and GST)• Ad valorem (property, inheritance)

A tax imposed on industry will cost differentially depending on abatement costs of each firm (H and L)

Total abatement is 80 + 20 Kg/mo

An emission tax may have a lower social compliance cost than a uniform standard

When abatements costs vary, a tax may be more cost-effective ($/kg controlled)

• If tax is $40/tonnes, Sludge Oil would continue to use process A and Northwest Lumber, would switch to process B, cut pollution by 1 tonnes only.

• If tax is $101/tonnes, Sludge Oil would now switch to process B and Northwest Lumber, would switch to process D, cut pollution by 4 tonnes.

• The total cost of the reduction would be only $280/day ($100/day for Sludge Oil and $180/day for Northwest Lumber), which is less than previously.

• The firm’s marginal benefit from any activity that reduces its pollution by one more tonne is exactly the amount of the tax (MB = MC).

What is the least costly way to cut pollution by half?


Note that this is a different way to represent MAC


MB = MC

Note – different way to show MAC

• Suppose the government could give two permits free of charge to each firm, allowing them to then sell or purchase permits.

• If Sludge Oil uses the permits, it will produce at point c, with the MAC at $400/day. If a permit on sale for $300, it is profitable for Sludge oil to buy it and produce at b.

• If Northwest Lumber uses the permits, it will produce at point C, with the MAC at $100/day. If it can sell a permit for $300, it is profitable for Northwest Lumber to sell it and produce at D.

• It has the same result as a tax method.

What will be the price of pollution permits?


Ch10-28© 2012 McGraw-Hill Ryerson Limited

Using taxes to drive alternative energy

• A claimed benefit of green taxes is to promote the development and adoption of alternative energy

• It does this by– Changing the relative price of conventional and

alternative energy– Direct investments (ear marked taxes)

• Can government make better investments than private sector

Costs of alternative energy

Table 1: Price range of renewable electricity by technology (2007) Technology Cents / kWh*

Wind 5.6 – 9.5

Geothermal 6.1 – 11

Biomass 4.5 – 13

Solar PV 23 – 42

Wave power 27 – 96

Tidal 20 – 39

Hydro power (including large-scale) 2.2 – 11 * Figures were converted to Canadian dollars using the exchange rate of June 8, 2009 (1.1161).

Wind Power

When negotiation between the private parties affected is costly or infeasible, goods with external costs tend to be overproduced.

Greenhouse Gases.– Public policy towards Greenhouse Gases:

• Reductions to be distributed so that marginal abatement cost —that is, the cost to a polluter of reducing Greenhouse Gases by one unit—is the same for all polluters.

• If different polluters have different marginal costs of pollution abatement, those approaches will not be efficient.

• Taxing pollution.• Pollution permits.

Environmental Policy and Externalities


Ch10-33© 2012 McGraw-Hill Ryerson Limited

Incentives and subsidies

• The reverse of taxation are rewards for good behaviour

• Subsidies are design to lower the costs of adopting new technologies or uses that are more expensive (private costs), but are believed to create social benefits.

• Common examples– Incentives to insulate– Cash for hybrid purchase

Selling Electricity Back to the Utility

Feed-in tariff – payment is above retail, and as the percentage of adopters increases, the FIT is reduced to the retail rate. The extra payment comes from the tax-payerNet metering – payment is always at the retail rate, and allows producers to use electricity at a different time than when it was generated. Power Purchase Agreement – treats epectricity producer as a conventional supplier below the retail rate, although some sources (solar) can be higher, because solar tends to be produced closer to during peak demand.

Summary of main policies for pollution control

Problems with pollution control policies

• Moral suasion is “preachy” and easy to ignore• Taxes tend to create adversarial situations between

government and citizens (households and businesses)• Subsidies are a transfer from the tax payer to the polluter and

are politically difficult is we reward polluters.• The private market approach (Coase Theorem) requires

assignment of rights and willingness of parties to negotiate• Transferable development rights

Transferable Development Permits TDP

• This is the core idea behind cap and trade programs• TDP is a government created market where

– A total emissions is set for everyone– everyone is allowed to pollute to a certain maximum for their

operasiton, and no more.– those who pollute less than this maximum are allowed to sell the right

to others who pollute more.• The idea is that to pollute more than the standard imposes an

additional cost. This will increase the incentive to cut back through introduction of new technology or changed practices.

Non-pollutors Polluters

Rights

$

In this case, pollution credits are awarded in proportion of the level emitted – 30 for A and 50 for B to reach a total of 80.

A receives 30 credits and B receives 50 credits.

An incentive exists to sell/buy if the MACs differ at the emission levels.

MACB

MACA

TDP – key issues• Can serve to define a target level of emissions like standard• Cost effective since the polluters must negotiate the trade.• It is not necessary for the MACs to be known – fairly good bet

that they are different.• Once the target is set, market transactions will identify the

MAC• As long as MACs differ, and prices “split” the difference,

trading should occur.• Both polluters will enjoy cost savings (gains from trade)

TDP – challenges

1. Initial rights allocation– cannot flood the market with rights– what rules are used to allocate rights

• Equal• Proportional to pollution

– Are rights free or sold?– The key is to distribute rights widely

Trading rules– Who is allowed to trade (best outcomes allow

free trades, however regulators usually want to meddle).

– Should advocacy groups be allowed to buy and burn? This will restrict supply drive up the price and discourage trading

– If the minimum is too low or two high… policy fails

TDP – challenges

3. Non-uniform/mixed emissions

TDP – challenges

Without the zones, those

polluters down wind may not

participate

Multiple trading zones create complexity

• Competition– Many buyers and sellers ensure efficient markets– TDP applied to specific areas may limit the

numbers interested in participating in the market– This is termed a “thin” market and is prone to

distortion (domination by a few sellers or buyers)

TDP – challenges

TDP ChallengesAsymmetric Information

• Basic private-value model - bidders know their own valuation, but no one else’s

• Pure common-value model – everyone values the item identically, but bidders have different information (private) on the true value

Example: Information on the amount of oil in the ground many vary among biddersExample: Pollution rights may depend on scope of contaminants to be covered (just COx or all

GHGs)

• Insider information can distort any market including an auction market• Nash Equilibrium: My bid depends on what I think your bid will be.

Example: If each market participant behaves as if there is no benefit by changing his or her strategy and everyone else does the same, the current set of market prices constitute a Nash equilibrium. Stated simply, A and B are in Nash equilibrium if A is making the best decision, taking into account B’s decision, and B is making the best decision, taking into account A's decision.

Objections to TDP

• Utilities that need to buy TDPs will pass it on as a tax (if they are allowed) and those who gain credits will increase profits.

• Firms can enter an industry to claim credits (scam the system).

• The market for TDPs must be efficient

Seclected video

http://www.youtube.com/watch?v=oqJO8HwxTkg&feature=relatedhttp://www.youtube.com/watch?v=uSNQzSjb38ghttps://www.youtube.com/watch?NR=1&v=y7veRksc_Yk&feature=endscreen

http://www.youtube.com/watch?v=oqJO8HwxTkg&feature=related

http://www.youtube.com/watch?v=uSNQzSjb38g

https://www.youtube.com/watch?NR=1&v=y7veRksc_Yk&feature=endscreen

• Externalities are the costs and benefits of activities that accrue to people who are not directly involved in those activities.

• According to the Coase theorem, the allocation of resources is efficient in such cases because the parties affected by externalities can compensate others for taking remedial action.

• The optimal amount of pollution reduction is the amount for which the marginal benefit of further reduction just equals the marginal cost.

• Defining and enforcing private rights that govern the use of valuable resources is often an effective solution to the tragedy of the commons.

• The difficulty of enforcing property rights in certain situations explains a variety of inefficient outcomes.

Chapter Summary

Chapter Summary Ch10-47© 2012 McGraw-Hill Ryerson Limited

• An efficient program for reducing pollution requires that marginal abatement cost be the same for all polluters.

• Either a properly designed tax on pollution or a system of pollution permits will have this property.

• Situations in which people’s rewards depend on how well they perform in relation to their rivals can give rise to positional externalities.

• Positional externalities tend to spawn positional arms races—escalating patterns of mutually offsetting investments in performance enhancement.

• Collective measures to curb positional arms races are known as positional arms control agreements.

Chapter Summary

Chapter Summary Ch10-48© 2012 McGraw-Hill Ryerson Limited

introduction to micro-economics externality - pollution

Documents

external costs

private costs

social costs

transactions costs

costs of negotiation

external benefits panel

benefits lo1

resource allocation